Against the Grain

Maverick

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Anyone who knows me well can attest that the world of science is not my strong suit. I managed to get through AP Chemistry through rote memorization and very little practical understanding of what on earth a “mole” or “Venn diagram” really means. If you want help on a paper maiche volcano or an explanation of what a gallbladder actually does, I am not your man for the job.

This is probably why I’ve always been under-allocated to science and healthcare-related stocks in my investment portfolio. I have no common sense gauge to judge the risk of a business or how they might stack up to their competition. With specific regards to biotech firms, I’ve always wanted to invest in them but the idea of relying on proprietary cures for diseases and ailments after years and years of regulated testing truly scares me.

Having said all of this, the ATG portfolio needs at least some healthcare/ biotech exposure. I’m going to have to get over my personal insecurities in the sector and rely on (i) external research and feedback and (ii) a review of their basic financials to select a security for the portfolio. After some basic screening, we are deciding whether to open a position in Gilead Sciences, Inc. (GILD).

GILD has been on my radar for a while through a personal connection. I have a friend who has worked for GILD for several years- unfortunately his frequent comments on the rapid growth and success of the company never quite resonated above the bar-room chatter about girls, sports, and who knows what else.

He directly recommended the stock to me again back in March 2014 (when it was around $70/ share) because the biotech stocks were getting hammered and he thought GILD’s earnings would pop with the release of their Hepatitis C drug Sovaldi. I didn’t bite simply because the P/E was still scary high and I couldn’t justify taking a flyer on a new drug release. When GILD reported Q1-14 earnings in April 2014, I wish I had trusted my friend’s inside perspective- GILD earnings tripled from the prior quarter with a 62% upside surprise to consensus estimates.

Ever since then, GILD has been on a tear to the point where their earnings (both on a trailing 12 months and forward year) now suggest value-stock pricing (14 trailing P/E and 10 forward P/E). Below is a charge of their earnings growth over the past three years:

In addition to an attractive P/E ratio, GILD has negligible debt, ample free cash flow, and a gaudy return on equity. Additionally, a few different research reports I read about the company alluded to their market-leading and “strong economic moat” position in Hep C and HIV treatment drugs. Sounds awesome, right?

Well, after a little juvenile research on their business I did find one red flag that causes me some concern. It turns out that one of their main money makers, the Hep C drug Sovaldi mentioned above, literally costs $1,000/ pill, which translates to over $80k for a basic treatment. In fact, they have a newer Hep C drug called Harvoni that will cost even more! Here’s where I get nervous- maybe their Hep C drug is so superior that the market simply has to accept this pricing. On the other hand, I can’t see Obamacare being down with covering that level of cost. If they drop the hammer, the universe of people that can pay for the treatment out of pocket is probably equivalent to the current number of Weight Watcher members (sorry- that’s a deeply painful, inside joke).

ATG needs some biotech/ healthcare exposure and I’m still intrigued by the stock- the financial metrics are right up our alley and analyst coverage on the stock remains fairly bullish from what I can tell. But my personal science background inadequacy and the $1,000 pill is giving me hesitation- please reach out to me if you have any advice or thoughts on this stock (or a better one in the sector)!!

I don’t think I could ever work for a macro-strategy investment company. When I hear about investment ideas centered around relative currency strength, anticipated interest rate movement, commodity prices, and yes, world-wide oil supply/ demand, my head starts to spin and I have trouble seeing the forest from the trees. I’m much more comfortable opining on whether I think people would prefer to eat a Big Mac or Whopper (and who has a better balance sheet) than what’s going to happen to worldwide beef prices because of the political situation in Brazil. That doesn’t mean that I don’t at least try to understand macro issues and their implications; rather, I try to know my limitations and keep the faith that my investment strategy will eventually weather various macro storms I don’t fully understand if I can find good value in great long-term businesses.

With oil prices down almost 50% in the last six months alone, every investment expert is weighing in with their view on how this will affect the market. It’s a complicated issue- obviously lower gas prices for consumers is great in that people can spend their money on other things and great for countries that rely on importing gas, but it’s not so great if energy-related loans start defaulting and impacting banks or the U.S. loses a big chunk of the previous job gains over the past 5 years that were energy related.

My conclusion on this whole issue is that I simply don’t know what’s going to happen with oil prices and how it will affect the overall market, so I’d like to explore opportunities within the market that are less impacted by oil prices (or ideally not at all impacted).

Below are some of my thoughts on stocks/ themes that meet two criteria: (i) I think they are good stand-alone investments ideas for 2015 and (ii) I don’t think that oil price movement (good or bad) will have a huge impact on their success or failure.

Battered down brand names/ re-positioning stories:

Weight Watchers (WTW): After a fantastic 50% run-up in the second half of 2014 due to new leadership, improved technology, earnings beats, and revised upward earnings estimates, the stock has mysteriously lost 30% in value over the past 3 weeks alone with no material news other than the fact that some people didn’t “like their new magazine layout”. I’m still a believer in what the new management team is doing and am looking forward to another nice run.

Hertz (HTZ): Despite being transportation related, I don’t think oil prices will swing the dial much for Hertz; it all comes down to whether the new leadership can execute a successful turnaround and restore investor confidence in their operations, strategy, and reporting. If they can, this stock has tremendous upside. If they can’t, you are at least left with an iconic brand name and infrastructure that is near impossible to replicate.

Lower-end consumer product and food companies:

YUM Brands (YUM): People might eat a little more junk food with lower oil prices, but a larger driver of growth for companies like YUM (parent company of KFC, Taco Bell, and Pizza Hut) is their ability to grow into new markets and take share from competitors. moMANon wrote a great piece on YUM and why he feels that the Pizza Hut re-branding has the potential to take some meaningful market share from its competitors and move the earnings dial for YUM.

Health/ organic oriented food companies:

Whitewave Foods (WWAV): The other day at the grocery store I was shocked to have paid more for a gallon of organic milk for my kids than I typically pay for a gallon of dairy alternatives like soy or almond milk. Oil prices won’t dictate whether people drink milk or diary alternatives, and Whitewave has been on fire with 10 straight quarters of beating earnings expectations, year-over-year revenue growth exceeding 40% and encouraging new partnerships in china to expand their reach. ATG is going long again on lactose intolerance.

High Tech:

My personal favorite play here is probably Corning (GLW), the leading manufacturer of durable glass for tv’s, phones, and tablets. I don’t have a great “ATG” theory of why they will outperform other than I just love the company, their market dominance, and ability to continue innovating over the past 100+ years. Google (GOOGL) also feels cheap to me right now, but if oil prices cause an overall market shock downwards for some reason, I could see the mega-cap, high trading volume companies getting crushed simply from investor fund withdrawals.

Non-equity income and dividend plays (non-energy related of course!):

There’s nothing wrong with parking some money in non-equity dividend plays if you are nervous about energy prices rocking the market. Within the ATG portfolio we have increased our allocation to iShares U.S. Preferred Stock ETF (PFF), a large basket of predominantly bank-related preferred shares that are currently yielding 6.33%. If low oil prices were to trigger bank defaults, PFF would certainly be impacted, but not nearly as much as the underlying equities would be impacted.

With over 3,000 publicly traded companies in the U.S. alone and who knows how many mutual funds and ETF’s, investors have plenty of opportunities to pick their spots and limit exposure to certain factors of their choosing. I’m not staying away from the market, but I am staring away from big oil price bets in my personal portfolio for now.

I need to tread lightly in this post for a few reasons, not the least of which is that there is overwhelming evidence that a long-term passive index investment strategy has significantly outperformed active investment managers (including mutual funds and hedge funds) over the past several years. In fact, I feel so uncertain about this post that I have to rely on a cute picture of one of my children to market the post!

Below is a passage from a Forbes article in August 2013 succinctly summarizing the data on active vs. passive investing:

“Using Morningstar’s fund database, we examined the performance of more than 2,000 active US equity funds during the 15-year period from July 1, 1998 to June 28, 2013. Result: only 25.6% of the active funds currently in existence outperformed their benchmarks (nearly 75% trailed the benchmark or had an insufficient track record to compare). Many other studies over extended time periods have reached a similar conclusion, including Standard & Poor’s, which found that 69% of all domestic equity funds were either outperformed after expenses by their benchmarks over the prior five years or had been liquidated during the period from Jan. 1, 2008 to Dec. 31, 2012 (Source: S&P Indices Versus Active Funds Scorecard).”

I don’t dispute the data. I also would never claim to be smarter than the average professional investor. But I truly believe that we are at a point where smart, active investment strategies grounded in value-investing principals are going to crush the index returns over the next twelve months, provided the fees are reasonable. The rationale boils down to timing- passive strategies tend to do their ass-kicking relative to active strategies in strong bull markets vs. sideways/ bear markets. And with the huge institutional investors like CalPERS now abandoning active investment managers for ETF’s, it will drive down the fees that active managers will charge and create opportunities for smaller investors to partner with the better active managers.

For everyone’s sake I hope the market continues to climb steadily, but muted GDP and real wage growth suggests we have a lot of catching up to do in justifying a continued stock market climb. The U.S. economy and stock market has amazing advantages relative to other investment options in the world due to job growth, a strong dollar and oil production, amongst other factors, but in the end it’s hard to build an argument for outsized U.S. stock market returns next year. There are still plenty of legitimate headwinds for continued growth- continued deficit woes, ineffective government, historically low labor participation rates, European stagnation, military instability via ISIS and Russia/ Ukraine, not to mention future problems from countries like Venezuela if oil prices spark political instability. Don’t get me wrong- I’m still bullish on the American economy in particular- I just think healthy investment returns over the next 12 months will require a manager who knows how to pick the right spots vs. the consensus view of an a passive index approach.

Recently Bloomberg published a great article about the demise of many hedge funds in light of their under-performance to passively-managed portfolios. Specifically, it references that through June 2014, 461 hedge funds had closed shop, the worst year for hedge fund closures since 2009. Check out the link for a full flavor of their perspective and video dialogue on the commentators’ perspective:

At the end of the day, I don’t have a crystal ball. But I do have my own personal investing experience over the past 20 years and gut intuition to believe that the current passive investing and ETF craze feels a bit like a bubble to me, despite ample amounts of credible evidence to the contrary.

Intuitively, how on earth can a competitive market be set for the fair value of investment securities if the majority of investment capital is being funneled via a passive vehicle that pays no heed to the intrinsic value of the asset? In other words, an asset needs to be rationally valued somehow- the less that the value is determined by informed investors vs. index allocations, the more that opportunity arises for smart, active investors who can pick their spots.

Did I mention that the ATG Fund will be open to outside investors January 1, 2015? Let me know if you are interested in learning more about the ATG investment fund and our specific strategies for 2015.

moMANon is pushing for an ATG position in American Capital Realty (ARCP), a large REIT focused on single tenant properties (including 500 Red Lobster locations) that has been at the forefront of scandal allegations over the past few weeks. Two weeks ago the stock started tanking on news that the FBI and SEC were investigating reports of accounting errors and potential fraud. The resulting drop in stock price has been dramatic- at one point the stock fell 37% to $7.85/ share from a price of $12.48/ share at the end of October before settling at $8.66 as of today. While nothing definitive has been announced, early indications are that the investigation centers around “improper accruals related to executive bonuses” as reported by none other than Ed Rendell, former Pennsylvania Governor and ARCP board member. At a minimum, it appears that some heads of ARCP management are likely to roll.

I’ve looked at ARCP before, but never had a good feeling about Nicholas Schorsch and his basic strategy of simply gobbling up as much single tenant real estate as humanly possible to package into a diversified alternative real estate investment vehicle. As of a few months ago, the 10%+ dividend offered seemed thin compared with the 7% cap rates he was paying for recent acquisitions, and I was convinced that rates would start ramping up (which clearly did not happen). The Red Lobster lease-back transaction helped boost his yields, but I don’t exactly see people flocking to Red Lobster in droves (aside from those few seeking the nostalgic euphoria of Cheddar Bay Biscuits).

moMANon’s suggestion to go long on ARCP amidst the current controversy is ballsy and contrarian, to say the least. Here’s a quick snapshot of the equity’s current ratings as reported by Schwab:

“F”, “Sell”, “Hold”, “Avoid”, you get the picture. After a quick gut check, however, I’m with moMANon on this one- ARCP appears oversold and ATG is going long on this REIT. Here’s a quick summary of what I like about it:

The stock trades at a material discount to book value at 0.74. In today’s environment it is very difficult to find a REIT trading at a discount to book value, particularly one with a portfolio that is 99% leased with an average remaining lease term of 12 years.

The REIT appears appropriately leveraged at approx. 55% loan to value with ample debt service cushion and an average interest rate of 3.55%.

The current scandal might actually turn into a positive situation for shareholders, preventing management from aggressively pursuing further growth in a frothy real estate market.

A monkey can manage a portfolio of singe tenant, triple net properties. Assuming no further acquisitions, it would be very, very difficult for management to screw up the management of a well-diversified, 99% leased portfolio of single tenant properties that have long lease terms. While it’s challenging to find a talented management team to execute an accretive growth strategy, it’s not challenging to find talented management to oversee a portfolio of low-maintenance assets trading at a discount to their intrinsic value. Any growth beyond responsible management is icing on the cake. (I think I just spent three sentences re-iterating the exact same point- at least it’s an important one 🙂

ARCP’s current forward dividend is 11.40%. The sustainability of this dividend is certainly questionable when looking at recent financials, but my rough back-of-the –envelope calculation for current cash flow yield is a very respectable 11% (Q2 2014 Earnings (with nominal sale activity) before depreciation/ amortization of $215 million, annualized against a current market cap of $7.81 billion). It appears that a substantial potential dividend drop despite ample cash flow support has been priced into the stock.

At a very rough gut-check level, I agree that the market value of ARCP’s portfolio materially exceeds the current enterprise value of $17.7 Billion ($178 psf on 99 million sf). $178 psf feels pretty cheap for a well-diversified, strong credit and fully leased portfolio with an average remaining lease term exceeding 12 years.

At the end of the day I think this is an opportunity to invest in a portfolio of stable, cash-flowing real estate assets that are worth more on the open market than the stock price suggests. Shady/ potentially unethical management has scared investors away in droves to the point where all it takes for this investment to succeed is some house cleaning at the front office and a new management team that can clip coupons and manage the debt side effectively. I’ll take that risk… and a double order of Cheddar Bay Biscuits!

I suppose it’s my turn to provide a quick take on the current make-up of ATG’s portfolio and thoughts on specific equities. While I have a few regrets (such as not buying Royal Caribbean at moMANon’s behest in hopes of buying a little cheaper and not picking up a larger entry position of Whitewave Foods), overall I’m happy with the current makeup of our portfolio and the various trades over its first 6 months.

OZM- At 16% of invested capital, Och-Ziff is our largest holding in the portfolio, more as a result of picking up more shares on weakness than overt confidence. I am extremely interested to see how their third quarter earnings pan out on November 4- the beauty of this stock is that they distribute most of their earnings as a dividend and it’s priced so cheap that their funds only need to gain a few ticks above 0% to generate adequate profits. The downside is that that they primarily play in international alternative investments, an area where getting a few ticks above 0% is no easy task in today’s environment. I’m a HOLD on this one.

ESV- Admittedly, I keep getting this stock wrong. It has been the worst performer of the ATG portfolio, with an unrealized loss of 13.5% to date. Plummeting oil prices coupled with concerns about over supply in the offshore rig industry have outweighed positive earnings results, a stable balance sheet, attractive dividend yields, and continued backlog of revenue for the company. Perhaps this is my version of the Ackman-Herbalife complex, but I’m convinced that ESV is destined to turn around- today’s earnings announcement of a solid beat and 3.2% gain is a good start. It’s hard to find a best-in-class company that generates ample profit, cash flow, and trades at a price below net book value of assets, even after excluding intangibles. I’m a believer in Ensco, but keeping a HOLD rating relative to the ATG portfolio given our large position.

GOOGL- I like monopolies, low leverage, strong revenue growth, and cutting edge technology investments at a price equal to the average S&P P/E ratio. STRONG BUY. We’ll be adding more soon.

VNM- Vietnam index, this is a tough one. I like this play a lot in the long run, but I’m annoyed by the nature of emerging market ETF’s like this where local players can anticipate the ETF buys for particular stocks in advance and move the market (increasing the ETF basis); I’m also cautious about emerging markets in general over the next couple of years. I think we’ll see a lot of volatility here and will need to buy on dips/ maybe sell on big upswings over the next year or so, hence the HOLD/ WATCHING WITH CAUTION rating.

HTZ- Hertz is a fascinating story, not too dissimilar to WTW: incredible overall market demand drivers for the industry but company-specific misteps and under-performance. If you missed my prior post on Hertz, check it out for more detail on why I’m intrigued, including how Carl Icahn bailed my ass out of the initial trade. We’re back in now that the stock has plummeted from $31/ share to around $20 share and has removed their CEO. While there may be some short-term turbulence as they eventually re-state their earnings and name a new permanent CEO, I’m extremely bullish on this stock over the next 12 months. STRONG BUY.

DE, PHM, DNOW, CLNY- I’m going to pull a Bill Simmons and group all these stocks together because (i) I’m lazy and (ii) they all share the similar characteristic of being what I consider relatively safer, industry leading stocks at attractive P/E ratios that I don’t lose any sleep over. We’ll buy on dips but they also aren’t likely to sky-rocket any time soon. The overall theme is increased importance on agricultural equipment/ farming efficiency, eventual millennial movement towards starting families and moving into new homes, continued energy/ oil industry growth in the US via a Warren Buffet supported spin-off, and attractive risk-adjusted real estate returns via a super smart shop that plays in both debt and equity (including rental residential).

WTW- In the last 3 months, Weight Watchers notched a staggering 53% gain from $19.25/ share to $29.42/ share before dropping 13% today despite a healthy earnings and revenue beat (but a 12% reported loss in overall membership). We’ve done well on this stock, and any reader of this blog knows that I’ve been cheer-leading it for over a year (admittedly more in bad times than good).

After reading the earnings transcript, the clear strategy set by new CEO Jim Chambers, and witnessing the measureable improvement of Weight Watcher’s technology presence (app integration with fitbit, iphone6, jawbone, etc.) I remain a steadfast believer in the stock.

The only caveat is that I actually did a little “gonzo investment research” and joined a new weight watchers group through my company to see what the program was like from the inside. I lasted one meeting- out of the total 18 people in attendance, there were literally 17 women staring down the 1 man with total disdain. I knew that Weight Watchers was overwhelmingly women, but I never fully appreciated the company’s challenge in attracting men to their onsite meetings until being there in person and feeling the awkwardness. I was very impressed by the initial Simple Start program and could immediately see the benefit of their group weight loss approach, but I think the programs need to be separated by gender if they ever hope to gain critical mass from the dudes. They also need a dude sponsor that men can actually relate to: Jonah Hill or Seth Rogan need to get fat again!!

As discussed in last week’s blog about spin-off opportunities, ATG will be taking a position in a recent spin-off company. That company is NOW Inc., (ticker DNOW), a $3 billion market cap oil services distribution company based out of Houston that spun-off from the $30 billion market cap National Oilwell Varco (NOV) back in May 2014.

When looking at spin-offs, the first question to ask is this- who’s likely to win from a spin-off… the former parent company or the new spin-off?? While not always a zero-sum game, it’s the question that I suppose separates the men from the boys in the world of special situation investing. In this case, I have a hard time coming to any strong opinion on the matter- National Oilwell Varco has been one of my favorite personal stocks for a while. After all, NOV’s long-term dominance in providing equipment and components to all phases of the oil and gas industry has earned them the nickname of “NOV- No Other Vendor”. Market leader, attractive P/E (10.5), low leverage, good return on equity (12%), solid earnings history… it has virtually all the traits that I covet when owning a stock.

According to the Form 10-12B filed in February, 2014 (Form 10’s are the formal notification documents when public companies intend to issue additional securities via IPO’s, secondary offerings, spin-offs etc.), NOV decided to spin their $3 Billion distribution arm off so that the separate entities could better focus on their particular niche and respective specialties- NOV as a drilling rig parts supplier and DNOW as a supply chain/ distribution provider to the oil and gas industry.

DNOW’s distribution arm has tended to be a lower margin business as compared with NOV’s main operations- by shedding DNOW they can improve their margins in hopes of getting a higher multiple on their stock. On the flipside, a separate distribution company for DNOW allows them to leverage dominant distribution channels and market product for new suppliers in addition to NOV.

Since the spin-off, both NOV and DNOW have had a similar trajectory, albeit that DNOW has been a tad more volatile, reaching gains north of 25% before dropping to 5% below their spin-off price in light of the recent oil price slide:

While I have a hard time coming up with reasons to knock the long-term opportunity of NOV, ATG ultimately made the decision to buy DNOW instead of NOV for the following reasons:

Merill Miller, the long-time CEO of NOV primarily responsible for their evolution into the dominant market leader for oil services stepped down from NOV in November 2013 in order to lead and serve as executive chairman of DNOW.

DNOW has effectively no debt on its balance sheet despite a well-established, profitable business. There is tremendous opportunity for accessing cheap capital to pursue growth opportunities.

As a $3 billion company (vs. NOV at $30 billion), DNOW has a larger runway for long-term growth prospects, particularly given the opportunity for them to market product from new suppliers.

The cyclicality of oil-related businesses and the glut of oil supply in the world today are serious risk factors in the near and medium term, but NOW feels like a good time to pick up a quality spin-off opportunity in DNOW for the long haul…

Despite the terrible title, “You Can be a Stock Market Genius” by Joel Greenblatt is on the short list of best investment books out there- probably my favorite. Joel is the founder of Gotham Capital and one of the most influential value and special situation investors around. I often use his value stock screening website for ideas (www.magicformulainvesting.com) and have been heavily influenced by his investment philosophy and approach to finding opportunities.

In the “Stock Market Genius” book, Joel spends a great deal of time discussing the general investment attraction of spinoff companies, which are companies that break off from larger public companies and operate as a stand-alone public company. A couple of irritating consequences of spin-offs create a source of opportunity in Joel’s view:

When people own a company that effects a spinoff, they tend to sell their spinoff company shares because they don’t want to take the time to evaluate a new stock and it’s usually a small position relative to their holdings in the former parent company.

Large money managers usually don’t focus on spinoffs simply because they are smaller in size and may fall outside of their index parameters.

Logically a parent company wouldn’t spin off and sell a piece of their business unless it was in their best interests- most investors are very hesitant to buy something that the insiders (who have way more information and insight into the business) are selling.

Joel boils it down to the idea that unlike an IPO, spinoffs are designed to give shares in a new company to people who probably don’t even want them, creating an initial negative price pressure on spinoffs that has nothing to do the quality of the company itself.

Now for the generalized bull case on Spinoffs:

Spinoffs often give executives a more direct opportunity to have their personal compensation relate to the success of the company itself. (An example might be if the dude who runs Frito Lay underneath Pepsi was given huge stock options in Frito as potential compensation as part of a spinoff).

Unburdened by a larger corporate environment, spinoffs often can be more nimble in decision making, capital allocation, and growth initiatives.

Parent companies usually retain a decent minority chunk of the spinoff company and have a vested interest in seeing the new company succeed. (Think of it like having a big brother that looks out for you as you start high school).

Every situation is unique and must be evaluated in earnest, but I agree with Joel that there are structural elements of spinoffs that have the potential to create outsized returns. His book cites research indicating that from 1963-1988, stocks of spinoff companies outperformed their industry peers and the S&P500 by about 10% per year in their first three years of independence. In looking how they might have performed as a group relative to the broader index more recently, I pulled up a chart of the Guggenheim Spin-Off ETF (CSD): Sure enough, the Spin-Off ETF handily beat the S&P 500 return over the past 7 years (about 80% gain vs. 45% for the S&P 500), although it should be noted that the superior performance of the ETF didn’t really start kicking in until 2013:

One of ATG’s holdings, White Wave Foods Company (WWAV), is a recent spinoff success story. Since parking from Dean Foods back in May of 2013, they have more than doubled their market cap through strong growth and investor appetite to pay a premium for companies that specialize in the organic food arena.

What’s the POINT of all of this?? A stock pick, of course! Stay tuned for Part II where we analyze an interesting spinoff that’s a strong contender for the portfolio.